Uncle Sammy loves kiddies. He also loves taxes. So, why not a kiddie tax! You've likely heard of the kiddie tax. It's not a tax on the number of children you have or anything like that, so don't fret too much. In fact, many people aren't touched at all by the kiddie tax.

So, what is it? Well, a number of years ago, Uncle Sammy realized that many people were passing assets to their children -- in the form of trusts, Uniform Gifts to Minors Act (UGMA), and Uniform Transfers to Minors Act (UTMA) accounts -- for one very simple reason: the children's tax rates were much lower than the parent's tax rates. It was a pretty nice loophole. But, like most good things, it didn't last. The kiddie tax made it a bit more difficult to squeeze through the loophole.

The so-called "kiddie tax" is not really a specific tax at all. Instead, it refers to the limitations that the IRS has placed on the ability of a child under the age of 14 to have unearned income taxed at the child's lower tax rate.

The "kiddie tax" provisions work like this:

The first $700 in unearned income (e.g., interest, dividends, capital gains, etc.) is not subject to tax, either at the child's rate or the parent's rate.

Unearned income of more than $700 and up to $1,400 is taxed at the child's rate (generally 15%, but usually much lower than the parent's rate).

Unearned income of more than $1,400 is taxed at an adjusted parent's rate (unless the child's rate is greater... not likely, but possible for some children in the entertainment industry).

The "kiddie tax" rules do not apply if:

The child is under age 14 and neither parent is alive at the end of the taxable year, or

The child is age 14 or older as of December 31st of the taxable year.

Filing the Tax

There are two ways to file and pay the "kiddie tax." The child can file her own return and compute the "kiddie tax" on Form 8615, or the parents can report the child's income on their own tax return using Form 8814. But, there are restrictions to reporting the child's income on the parent's tax return. Form 8814 can only be filed if:

The child's income is from interest and dividends only. (This means that, if the child had any sales of stocks, bonds, or mutual fund shares, some of the income or loss will be from capital gains -- and filing Form 8814 will not be allowed.)

The child's gross income for the year is less than $7,000.

No prior-year estimated tax overpayments are applied to the child's current-year return; and

No estimated tax or withholding tax has been paid in the child's name.

So, be sure to keep these restrictions in mind when making your decision.

Before passage of the Small Business Protection Act in August of 1996, the best method for reporting a child's income was almost always: "File the child's return alone, using Form 8615." But, that Act corrected the quirk in the law that provided a greater benefit for the child filing an individual return. Now that parent and child are back on a more level playing field, you must determine the most appropriate method for your situation.

Advantages of filing the child's income on the parent's return would include:

No need for the hassle of filing a separate return for the child.

The parent's net investment income might be increased, which can allow a larger investment interest deduction for the parent.

Since charitable contribution deductions are generally limited to 50% of Adjusted Gross Income (AGI) -- which can drop to 30% or even 20%, depending on the charity involved -- the increased AGI can allow for an increased deduction for large charitable contributions.

The first $1,400 of the child's income is taxed on Form 8814 and is not included in the parent's taxable income. This might reduce state tax liability in states that base income tax on the federal taxable income.

If the child files his own return, he could be subject to the Alternative Minimum Tax (AMT), but the AMT might not kick in when reporting on the parent's return.

Disadvantages to reporting the child's income on the parent's tax return:

The additional income can accelerate the phase-out of itemized deductions due to Adjusted Gross Income (AGI) limitations. Such deductions might include the medical expense deduction, the deduction for casualty and theft losses, and miscellaneous itemized deductions.

The additional income can reduce the $25,000 rental loss allowable for active participation.

Because of the increase in the parent's AGI, their ability to deduct an IRA contribution might be phased out or eliminated. It's even possible that the additional income could prohibit a conversion from a regular IRA to a Roth IRA. And, this increase in the parent's AGI might also impact other issues that are based on AGI, such as the taxability of Social Security benefits.

The additional income might reduce the earned income credit, the child tax credit, the dependent care credit, the Hope credit, the Lifetime Learning credit, or any other credits that are based on AGI.

The additional income might result in higher state tax liability for states that base their state income tax on federal AGI.

How to Beat the System

First, if at all possible, keep the reported unearned income below $700 for each child until they reach age 14. Barring that, at least keep the income below $1,400 to avoid paying tax on the unearned income at the adjusted parent's tax rate (more on that rate later).

How to do this, you ask?

Series EE Savings Bonds are a good technique. Certainly not very Foolish, but you can elect that the interest on the bonds not be recognized until sometime after the child reaches age 14.

Invest in growth stocks that don't pay dividends and that you likely won't sell until after the child reaches age 14.

Watch out with mutual funds. They are required to pay out dividends and capital gains on an annual basis, resulting in... oops... unearned income. Instead of mutual funds, you might want to plan on building a stock portfolio for your child.

And, for goodness sake, don't invest in double-tax-free municipal bonds or municipal bond funds to avoid the kiddie tax until the child's taxable earned income is greater than $1,400. Why? These instruments pay a lower interest rate because of the tax-free benefit. If the child's unearned investment income is less than $700, you won't owe tax on it anyway, and the next $700 will only be taxed at the child's rate (usually 15%)... so there's very little tax "benefit" until the tax "burden" is higher.

The Tax Rate for Income Above $1,400 Per Year

The tax rate used to compute the "kiddie tax" is the rate that would apply to the parent(s) if the child's net unearned income were added to the parent's taxable income. This could put the child's income in a higher tax bracket than the parent's... if the parents are right at the very top end of a tax bracket. The additional income might push them "over the top," and the child's marginal tax rate could be higher than the parent's marginal tax rate.

The Multiple Children Problem

Having two or more children confuses the issue. The tax rate for the children is now computed by adding the net unearned income of all under-age-14 children to the parent's taxable income. The resulting tax is allocated among the children based on their share of income.

The "kiddie tax," while a valuable part of your tax strategy, can lead to some confusion. Keeping the above tips in mind while planning your children's investments will help you avoid kiddie tax pitfalls. IRS Publication 929, Tax Rules for Children and Dependents is also helpful.

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